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Business Services Stock Outlook - October 2016

The business services sector provides ancillary services to the other players in the market. Hence, the core business of one company in this sector can be a business service for another. Importantly, this dynamism opens the door to many business services companies.

Notably, business service accounts for a major portion of a country’s gross domestic product (GDP) with the gradual shift in the global economy having moved from agriculture to industry to now business services. The sector, therefore, plays a major role in a country’s overall development.

The intensely competitive business services sector must rigorously work toward controlling costs and generating higher revenues so that its profitability does not suffer. A focus on functions and activities close to its core competence is a prerequisite in reaping the benefits of economies of scale, besides improving competitive positioning.

The fortunes of business service operators are closely tied to the health of the broader economy. As per the U.S. Bureau of Economic Analysis (BEA), domestic economy has been expanding (at a rate of 0.8% in the first quarter of 2016 and 1.4% in the second quarter) on higher contribution from personal consumption expenditures and increased residential fixed investment. The growth momentum is now expected to accelerate by 1.5% in 2016 and 2.5% in 2017.

This improving outlook for the U.S. economy is therefore a net positive for the sector. Though the bureau presently estimates total industrial production to decline 1% in 2016, the same is expected to be on the growth trajectory in 2017, with an estimated increase of 1.4%, thus offering opportunities of growth and expansion to business service providers. Moreover, a projected rise in expenditure should lend support to the business service sector.

Economic sensitivity aside, business service companies are quite conservatively managed, with a large number of players sharing their excess cash with shareholders through dividends and share buybacks.

Nonetheless, the business service sector is highly fragmented, with no single service provider enjoying market dominance. As per business reports, the top 50 companies of the sector contribute less than 25% to the overall revenue. However, given its unique nature, Zacks has classified the group as one of the 16 sectors (the S&P’s official GIC classification has only 10 sectors where business services are grouped within the ‘Industrials’ sector). Notably, with about 3.4% of total market capitalization, the sector is estimated to have 2.9% share of income in 2016.

Stand-Alone Zacks Sector

This industry covers an array of services that include marketing, consulting, staffing, security, telecommunications, Internet services, logistics and waste handling. In its expanded sense, the U.S. business services sector generates consolidated yearly revenues of about $620 billion, though many companies mentioned below do not strictly fall within the generally accepted definition of the industry.

Within the Zacks Industry classification, we have divided the business world into 16 sectors comprising 60 industries (at the medium or M-level) and 256 industries at the expanded or X-level. We rank all 256 X-level industries in the 16 sectors based on the earnings outlook of the constituent companies in each industry. This ranking is available in the Zacks Industry Rank page.

The way to align the ranking and outlook from the complete list of Zacks Industry Rank for the 257+ industries is by dividing it into positive, neutral and negative categories depending on the Zacks Rank. The outlook for the top one-third of the list (Rank of #88 and lower) is positive, the middle one-third of the list (Rank of #89 to #176) is neutral while that for the bottom one-third (Rank #177 and higher) is a clear negative.

Please note that the Zacks Rank for stocks – the core of our Industry Rank – has an impressive track, verified by outside auditors, to foretell stock prices, in particular over the short term (one to three months). We have eight X-level industries within the Business Services sector, namely, Auction/Valuation Services, Business Information Services, Business Services, Consulting, Financial Transaction Services, Outsourcing, Staffing and Waste Removal Services.

Auction/Valuation Service ranked #9 is the only industry that falls in the upper 1/3 and has a positive outlook.

Business Information Services with a rank #96, Business Services at #114, Financial Transaction Services #164 and, and Consulting ranked #165, are positioned in the mid 1/3 of all Zacks industries and have a neutral outlook.

Outsourcing at #181, Waste Removal at #213 and Staffing at rank #230 are industries that fall in the lower 1/3 and have a negative outlook.

This allocation points to a neutral to negative outlook for the sector.

The third-quarter earnings season has commenced with 13% of business service providers having already reported their numbers. The sector’s earnings witnessed 19.8% growth on 10.3% revenue improvement. The figures compare favorably with the numbers delivered by the S&P 500 (1.3% earnings increase on revenue improvement of 2.9%). Beat ratio of 100% for earnings and revenue compare favorably with the S&P 500.

Overall earnings for the third quarter are estimated to increase 7.1% for the sector versus a 2.9% decline for the S&P 500. Revenues on the other hand are expected to exhibit growth of 8.6% versus 1.2% for the S&P 500.

For full-year 2016, earnings for the business service sector are estimated to increase 3.8% on 5.4% revenue improvement. This compares favorably with the S&P 500’s expected earnings decline of 2.5% with revenues likely to remain flat with the 2015 level.

The graph below shows year-over-year bottom-line growth of the business service (BS) sector in comparison to the S&P 500.

The graph below shows year-over-year top-line growth of the BS sector in comparison to the S&P 500.

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